Is diversification dead?

by VINCENT de MARTEL and KEVIN KNEAFSEY

e same direction:down. With the exception of government bonds, no asset class—including alternatives— tors from the cr s as if diversianalysis reveals tworeturThese two fundamental risk factors— which permeate all asset classes—canexplain current returns, not the end of diversification.As the credit crisis unfolds, significantopportunities exist for investors who takerisk premia othere current marketsustained in theun. Looking at market conditionsthrough the lens of liquidity risk premia,signs are emerging thatthe only dereturns. Investors seeadjusted long-term retunot only across asset classes but alsoacross risk premia.EXECUTIVE SUMMARYSince the summer of 2007, asset-class returns have been headed in thhas protected invesedit crisis.fication has failed investors. Ourns:advantage of oversoldthan liquidity. Some of thdislocations cannot belong rOn the surface, it lookfactors behind these extreme•

A flight to quality, and•

Extreme liquidity demand.this is no longerterminant factor explainingking higher risk-rns should diversify

Solutions

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MARCH 2009

Volume 1, Issue 2|

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INTRODUCTION

d manceese concepts, whichwe rely on heavily, depends on the answeIs it possible that the one free lunch of investing hasbeen taken from us? What fundamental chageshave occurred that impact diversification? And hownew environment? Toanswer these questions, we will briefly explore recentperformance and then look to the future to applyication has fared, we canlook at recent correlation data. Figures 1 and 2 plot rolling12-month correlations between developed equitiesand various asset classes over the last three years.

Source: Bloomberg, 01/05 to 12/08. Indices include: MSCI World Standard Core Gross Index Local Currency, Citigroup WGBI 7–10 Year Local Currency Total Return, Barclays Capital Global Aggregate Corporates Total Return Hedged, Barclays Capital US Corporate High Yield Total Return.

Events of the last 18 months have causeconcepts of conventional wisdom in finanyto beshould portfolios adapt to thiscalled into question. One of thr tothese findings.To get a sense of how diversif the question: Is diversification dead?n

FIGURE 1: ROLLING 12-MONTH CORRELATIONS BETWEEN DEVELOPED EQUITIES AND VARIOUS BOND INDICES

-1.0-0.8-0.6-0.400.20.40.6

High-yield debt

-0.2

0.81.0

Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08

Investment-gradedebtDeveloped sovereign debt

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SCI WA/NAREIT Global Total Return, –AIG E

heseespeciallyover short periods. Reliance on them as if theyportray highly stable relationships is unwarranted.

•

Correlations between the highest-quality investments— developed market sovereign debt—and riskierinvestments have been strongly negative.

•

Correlations between risky assets have increasedsignificantly, and in many cases are approachingnear-perfect positive levels.All risky asset classes appear to have moved in thesame direction at the same time, which is expressedby their higher correlations through 2008. This isprecisely what diversification was meant to avoid.Before we conclude that the theory of diversificationis flawed, we must look beyond correlations.

Source: Bloomberg, 01/05 to 12/08. Indices include: MDow Jones–AIG ExEnergy Total Return, and Dow Jones

orld Standard Core Gross Index Local Currency, FTSE EPRnergy Total Return.